Should You Include Emergency Fund and Specifically-Earmarked Savings in Your Overall Asset Allocation?

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On New Year’s Eve before the official start of 2013, I posted an article mentioning that I was updating my target asset allocation to a 70% equity / 30% fixed income split, up 5% from the 75% equity / 25% fixed income split I had been using since I started this blog in 2010. Using the 25/75% split in overall asset allocation, it boiled down to having 5% of my overall assets held in cash. 

The reason that I changed my asset allocation targets to 30/70% stemmed from the fact that during the past year with the accumulation of specifically-earmarked vacation savings, dream and life values savings, and my emergency fund, I have tended to carry around 10% of my overall assets in cash-equivalent accounts. Since I like having this amount of cash on hand being saved for specific purposes, I figured it was about time for me to accept the fact that I need to change my target asset allocation percentages to account for this preference – hence the change.

When I made the change mentioned above, it seemed to make a lot of sense, and I didn’t think much of it at all. However, several days ago, a reader brought up the question below, which made me think about reconsidering my strategy:

Should savings that are earmarked for specific short/intermediate-term needs (vacations, buying a car, home down payment, college savings, doggie emergency fund, buying a new $3,000 bike, saving for a pool, saving for a rental real estate investment) and one’s emergency fund be included in your long-term asset allocation percentages? Or, should it be considered as a completely separate basket(s)?

Let’s explore an answer to this question, shall we?

Reasons FOR Including These Savings in Your Long-Term Asset Allocation 

In the process of learning about personal finance through reading many of my favorite books throughout the past 7 years or so, there is one consistent message in the majority of them when they talk about investing – that money held in different baskets (Roth IRA, IRA, 401k, taxable investing account, etc) should be counted together as one common portfolio / asset allocation.

Because of this common theme around considering your investments (generally, the authors either explicitly or implicitly are describing retirement / long-term investing) as ONE portfolio instead of many, I imagine that many folks out there (like me!) carry this same strategy through to how they treat their cash savings earmarked for specific purposes and their emergency fund – they simply count these funds as part of their long-term asset allocation / overall portfolio.

However, does this same advice actually still apply for one’s tactical cash savings?

On one hand, I suppose the argument could be made for including earmarked savings in your long-term asset allocation on the basis that…

• Doing so will provide you with a more accurate, global view of your overall finances (it is YOUR cash after all, so why wouldn’t you count it in YOUR asset allocation?) 
• Doing so gives you a more accurate feel for the level of secure holdings you are carrying.
• If you’re like me, these earmarked and emergency fund savings were taken in to consideration when I calculated my fixed income asset allocation. 
• Even though you’re investing for the long-run, if a financial emergency pops up, you’re going to use whatever money you have access to in your ENTIRE asset allocation, so why not treat it all as the same pile of money?

However, if we look in to the issue in a little more depth, do these reasons still hold true?

Reasons for NOT Including These Savings in Your Long-Term Asset Allocation 

Even though I do include my emergency fund and other intermediate-term cash savings in my retirement asset allocation, one thing that I do NOT include is the savings that I accumulate each year for paying estimated income tax from un-taxed self employment and graduate fellowship income. The reason for this exclusion is because the money comes in and out of my portfolio so quickly (1 year or less) that the only thing it would do is skew my asset allocation percentages to make me think I am holding more cash than I am. In addition, these estimated tax savings were not taken in to consideration when I calculated my fixed income asset allocation.

Reason # 1 – Including the Savings Makes You Think Your Holdings are More Conservative Than They Really Are

When I really started thinking about it, I realized that it could be argued that including tactical savings in your asset allocation is wrong because it makes your investments seem more conservative than they really are.

An example illustrates this very nicely, in my opinion.

Let’s consider that someone has an overall net worth of $100,000. She uses a 40% fixed income / 60% equity overall asset allocation split. The fixed income allocation includes a $10,000 emergency fund (10% of the total allocation), which the investor has determined based on her specific monthly expenses to be enough to sustain her and her family for 6 months of life should she get fired from her job.

Let’s assume that the unthinkable happens. Her job gets downsized, and her salary all of the sudden vanishes. Fast-forward 6 months. Her emergency fund cash savings of $10,000 are now gone. If all else stayed the same, her asset allocation would now be 70% equity / 30% fixed income. If she had developed her asset allocation with her emergency fund in mind, then this might be all right. However, if not, she might be a little too much exposed to risk.

Reason # 2 – Earmarked Savings Cannot Be Rebalanced to Maintain Your Target Asset Allocation

At first glance, a compelling reason against including earmarked savings in your asset allocation is that similar to your home, it really doesn’t make sense / is not easily possible to rebalance when it comes to your emergency fund or earmarked savings, since these amounts are specifically chosen for certain needs/values/wants.

However, if we examine how these cash savings fit within an overall portfolio, I feel this potential problem becomes a lesser issue. For example, in my portfolio, my emergency fund and earmarked savings fit in to the 10% cash allocation, which along with 5% TIPS and 15% short-term bond funds, makes up my 30% fixed income asset allocation. If the equity markets were to decrease significantly, I would find myself needing to sell these various fixed income asset classes to maintain the proper risk exposure. Naturally, I wouldn’t be able to sell my emergency fund savings, etc, but I would be able to sell my other cash accounts and bond mutual funds in order to maintain the right allocation. Thus, I think everything would work itself out fine.

Conclusion

Having investigated all of these considerations, what’s the verdict? Should your emergency fund and other short/intermediate cash savings be included in your asset allocation, or not?

As with many things in personal finance, I think the answer to this is that it depends. More specifically, it depends on how your fixed income asset allocation targets were calculated in the first place (but that either way is probably just fine).

• If they were calculated solely taking in to consideration qualitatively how much variation in your portfolio you can handle whilst still being able to sleep at night, then I would recommend NOT including your emergency fund, etc in your asset allocation totals.
• If on the other hand, your fixed income asset allocation target was calculated (as I did mine) more conservatively by considering both how much variation you can tolerate from a qualitative perspective and listing out your specific cash needs, then including your emergency fund, etc in your asset allocation calculations is fine!

How about you all? Do you include your emergency fund and short/intermediate-term cash savings in your overall asset allocation, or treat them as their own separate “pools?”

Share your experiences by commenting below!

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